Azerbaijani bank’s murabaha will develop Islamic banking market

The central Asian republics have seen limited growth in Islamic banking but International Bank of Azerbaijan's recent $100 million syndicated murabaha to finance its new Islamic window opens up another market to Islamic banking.  

The opening of one Islamic window is not likely to swing the gates to CIS open wide to Islamic financial institutions, but the participation of the International Bank of Azerbaijan is likely to represent broader government support (by virtue of the Ministry of Finance’s 51% ownership of the bank) for changes that will likely have to be enacted to facilitate Islamic finance in the country.

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ICD head gives interview to Arab News

Arab News had an interview with the CEO of the Islamic Corporation for the Development of the Private Sector, Khaled Al-Aboodi.  The ICD is the private sector arm of the Islamic Development Bank (similar to the relationship between the International Finance Corporation and the World Bank).  Here are a few sections that I thought were interesting: 

"While lack of access to finance by the private sector has opened new opportunities for ICD to support private sector development in a number of member-countries, a combination of factors such as social unrest in some member-countries, increased cost of funding and lingering effects of financial crisis has made it very difficult for ICD to operate as planned."

 ....

"ICD managed to approve 18 new projects and capital incease for three existing equity projects totaling 372.26 million in 1432H/2011. This was 58 percent higher than the previous year (2010), which reflects ICD's continuing robust support to private sector development in the member-countries. Equity investments accounted for the bulk of ICD's 1432H/2011 approvals, representing 38 percent of the total, followed by the line of finance (35 percent), long-term financing (22 percent), and short-term murabaha (5 percent). In terms of sectoral distribution, the three main beneficiary sectors were finance, industry and real estate, jointly attracting 85 percent of the total approvals. The financial sector accounted for the biggest allocation, totaling 201.26 million, or 54 percent of the 1432H/2011 approvals. In terms of regional composition, 31 percent of ICD's approved projects during 1432H were allocated to the Middle East North Africa (MENA) region, followed by South Asia (23 percent), Sub-Saharan Africa (16 percent), East Asia and Pacific (14 percent), and Europe and Central Asia (10 percent). In terms of recipient countries, ICD approvals were extended to 13-member countries, including three new countries - Algeria, Gabon and Turkmenistan. "

...

"In the past year, ICD successfully closed the fund-raising for Tunisia and Saudi Arabia SME funds, and also for the Central Asia Renewable Energy Fund. Furthermore, ICD has approved establishment of a Food & Agriculture Fund and Fixed Income Fund, and successfully secured some mandates in Tunisia and Cameroon for capacity building and creation of Islamic windows within conventional banks."

...

"To fulfill our mandate, we support the private sector through the following ways: First, we assist them alone or in collaboration with other financing institutions the establishment and expansion of enterprises. Second, we can make direct investment, through Islamic instruments, in the subscription and purchase of their share capital. We also promote with participation of other sources of financing, including the structuring of syndication deals, underwriting of securities, joint ventures and other forms of association. Moreover, we can get involved in issuing mudharba, leasing and istisna'a bonds and other financial instruments. At the top of these, private sector firms may benefit from our advisory services and technical assistance programs."

 ...

"ICD's accumulated approvals since it began operation reached 2.17 billion by the end of 1432H/2011, which has been allocated to 218 projects. The corporation approved about 60 percent of its investments through two main modes of finance - equity and murabaha. The cumulative gross approvals of ICD by mode of finance include 766.07 million of equity, 535.77 million of murabaha, 526.5 million of ijara, 223.13 million of installment sale, and 119.14 million of istisna'a. "

"The financial sector accounted for the largest share, amounting to 783.7 million, or 36 percent of the accumulated gross approvals since inception. The industrial sector had the second largest share with a total approved amount of 596.1 million, representing 27 percent of the gross approvals. This was followed by real estate, with a total approval of 276.2 million (13 percent)."

One thing I think is notable is that the ICD is becoming involved with both SME financing and renewable energy financing, which I have mentioned as important areas for Islamic finance several times.  One question that arose for me when comparing the inception-to-date statistics with the 2011 data was what the breakdown in terms of structure used by the ICD.  The inception-to-date numbers break down by equity, murabaha, ijara, installment sale and istisna'a, but the 2011 data show equity, line of finance, long-term finance, short-term murabaha. The data are not comparable without making some perhaps heroic assumptions about what structure is used for "line of finance" and "long-term finance" (which may be murabaha and ijara, respectively, but could combine a number of different structures in each category). 

Click through to the full article to read the rest of the interview. 

World Council on Credit Unions may take lessons from Afghanistan to Libya

The World Council of Credit Unions has spent the past 8 years building 34 Islamic Investment and Finance Cooperatives across Afghanistan providing murabaha, ijara and a murabaha-ijara hybrid product to its 92,456 member-owned cooperatives (here's the WOCCU's page on the IIFCs).  Now it is shifting its attention to Libya where there CEO of San Francisco Federal Credit Union said "As the country reconstructs, it is an opportunity for credit unions to participate in rebuilding the economy."

It would be useful to see the development of more Islamic credit unions, particularly in countries where access to finance (of any kind, conventional or Islamic) is low because the credit union model has a seeming overlap with Islamic banking.  Depositors of the credit union are members (i.e. owners) of the credit union and the return they get on the use of their deposits are returned to them as profit.  While there are still aspects where the credit union will replicate how banks work (for example, losses are unlikely to be passed through to depositors unless the credit union fails), there are fewer areas where there are difficult contradictions inherent in the model.

For example, if an Islamic bank goes out and tries to attract deposits using the mudaraba structure, they would be theoretically at risk of loss if the investments made with the deposits lose money.  Yet, how is that different from the equity owners of the bank, who should in theory have the same risk-return profile.  One difference between the mudaraba depositors and the equity investors is that the investors would have the right to participate in some ways in the management of the bank where the depositors wouldn't. 

However, that would make the structure of an Islamic bank more beset with conflicts of interest than a credit union (where members provide deposits and also act as the owners of the bank, which is typically a non-profit).  The equity investors (musharaka partners, essentially, have a right to a portion of the bank's earnings, much of which is made using the funds provided by depositors (the mudarib fee in the mudaraba arrangement).  The depositors are liable for the loss of their deposits if the investments are poorly chosen, and are entitled to the share of the profits accruing to them as the rabb al-maal but have no rights to direct the management of the bank. 

In the actual operation of Islamic banks, depositors are treated as being senior to the equity holders (they will have their deposits paid first if the bank were wound up, with any residual accruing to the equity holders).  That introduces an additional potential conflict of interest where the bank's equity owners would benefit from gains but would not have as much at risk to loss if the bank failed (since they would be investing with their equity capital plus the deposits).  This conflict of interest, of course, is the reason why banks (including Islamic banks) are so highly regulated. 

However, from the perspective of choosing whether an Islamic banking entity would work better using musharaka equity investments alongside mudaraba deposits as a privately held bank or a member-owned credit union, I think there is a lot to be said that the credit union would be better because the potential conflict of interest between the depositors and the equity owners would be eliminated by making the depositors the owners of the credit union.  There remains still, of course, the governance challenge of aligning management and depositor/member interests in a credit union, but using a structure with fewer conflicts to manage seems like a better way to go. 

Oman's CMA releases draft sukuk rules

Last week, in a post I questioned whether there was scope for arbitrage between the restrictions on tawarruq for banks and the rules on sukuk, which were laid out in descriptive form in the Islamic Banking Regulatory Framework, subject to final rulemaking by the Capital Markets Authority (CMA).  In the letter to banks from the Central Bank of Oman (CBO) sent with the rules which I had not seen (and a reader of the blog helpfully sent me), the CBO highlighted that with respects to sukuk, "Licensees shall note that business, authorized under IBRF will be subjected to general/specific approvals and restrictions.  Licensees should, in particular, note that certain enabling provisions/reference to Sukuk, Securitization, subsidiary etc., in-built for possible roll-out, do not accrue to Licensees automatically and shall depend upon future policies/authorizations/enablers"

Now that the CMA released rules, there are a few additional safeguards to avoid murabaha sukuk to be used by non-banks as backdoor sources of tawarruq which are interesting not only for Oman, but for Islamic finance in general in providing sufficient transparency for both regulators and for sukuk holders, that will provide more benefit than just cutting off potential for regulatory arbitrage.  The CMA draft rules (PDF) state:

The Sukukholders' agent shall monitor the Obligor's and the Sukuk Issuer's performance in respect of their obligations as mentioned in the prospectus, and shall seek to protect Sukukholders' interests. In particular, it shall be responsible for the following:
[...]ascertaining that the funds raised through the issue of the Sukuk are utilised in accordance with the prospectus;

The rules from the CBO already restrict sukuk issuers from issuing sukuk for "general unspecified purposes".  Whether or not that limits the use of sukuk for 'general working capital', there will be some oversight from the CMA on each individual sukuk, since they must be reviewed and approved by the CMA, and the Sukukholders' agent has an obligation to ensure that the funds are used for the approved purpose. 

It will be interesting to see the first few sukuk issued from Omani companies to see how specific they are on the use of the proceeds, and whether it could be applied in other countries to make sukuk offering documents more transparent. 

Oman's prohibition of tawarruq and murabaha sukuk

The Omani banking law is notable in many ways, but the most discussed way is that it prohibits--with very few exceptions--the use of commodity murabaha (tawarruq) (CMT).  The exceptions are narrow: an Islamic bank is permitted to use CMT if its "survival is genuinely threatened, or in case of a conventional bank's conversion into Islamic where no other alternative mechanism exists to convert part or all of its portfolio, as determined by the bank's SSB".  Any use of the CMT requires Central Bank approval, which should be effective in limiting the times it is used.  In any case, it cannot be rolled over and so it can only be used for three months. 

However, the concept of murabaha is usable, in particular, through sukuk.  The Islamic banking law describes: "Murabaha Sukuk are certificates of equal value issued for the purpose of financing the purchase of goods through Murabaha, in which the certificate holders are granted ownership of the Murabaha commodity".  The transaction has four steps:

1) The SPV set up by the company looking to finance the acquisition of a particular asset and issues sukuk certificates, selling them at par;
2) The SPV buys the asset needed by the company (the originator), using the proceeds of the sukuk issuance;
3) The SPV sells the asset to the originator in exchange for the commitment of the originator to pay their value, plus a fixed profit margin, with set payment terms;
4) The originator makes payments and when the final payment is made (either of the par value if it pays profit during the term of the sukuk or of the full cost plus profit amount) the proceeds are passed along to investors and the sukuk certificates are redeemed.  

Nothing in the above description above varies from the typical structure used in murabaha sukuk (nor would it be expected since the rules require compliance with AAOIFI standards).  However, what is not mentioned, and I cannot find in the rules, is whether there is approval of the purpose of the sukuk issuance. 

What I mean here is that there is not a stipulated requirement that I can find for the murabaha sukuk to be approved by the central bank to determine whether it is a straight murabaha, or if the murabaha sukuk (or presumably any other murabaha financing) could be turned into a tawarruq.  The law is pretty clear that CMT is prohibited for Islamic banks, so it would rule out this situation for Islamic banks (the Central Bank of Oman, in its capacity as regulator, would presumably review any murabaha undertaken by a bank to ensure it was not in violation of the prohibition of CMT).

However, it is unclear whether there would be oversight from the Capital Markets Authority (CMA), which would likely fill the role of regulator of any sukuk issuance by non-financial companies.  I don't think the rules for sukuk are available yet from the Omani CMA (please tell me if they are) and they may cover this, but from the searching through the Islamic banking law, the closest I can find is:

The funds raised through the issuance of Sukuk should be applied to investment in specified assets rather than for general unspecified purposes.  This implies that identifiable assets should provide the basis for Sukuk.

Otherwise, what would be stopping a company in need of capital from issuing a sukuk to acquire 600 MT of nickel for $10 million and then in a separate transaction selling the nickel to realize $9.8 million in proceeds.  Perhaps there would be a way for the CMA to target the issuer for failing to disclose accurately the reason for the sukuk (since it could not just be issued for 'general corporate purposes').  I would hope that there is some clarity when the CMA releases its guidelines for sukuk issuers that include some ex post review of the use of the assets to ensure that they are used for the stated purposes, but regardless it introduces some uncertainty. 

Dr. Zeti speaks on the shift towards equity-based Islamic financing

Dr. Zeti Akhtar Aziz, the governor of Bank Negara Malaysia, spoke today at the Islamic Development Bank's Regional Lecture Series in Indonesia, and while there was nothing groundbreaking contained in her speech, there were a few parts that I think are important to remember (and I would recommend again that when Dr. Zeti speaks it is wise to be listening). A few quotes:

The recent global financial crisis provides a distinct example of how excessive leverage and exponential growth in financial activities that are detached from the growth trajectory of the real economy can become a source of instability. Leverage increased sharply in the years leading to the crisis, buoyed by years of strong economic growth. In the advanced economies, bank balance sheets exploded, growing to multiples of annual GDP.
[...]

The sheer size, complexity and leverage in the banking system increased the fragility of financial institutions and limited their ability to absorb even small losses, thereby resulting in widespread and deep economic dislocations.

[...] 

There is also strong discouragement against excessive risk undertakings and a prohibition against speculative elements. These rulings also serve to insulate the Islamic financial system from excessive leverage, which in turn contributes towards promoting financial stability and its long-term sustainability. These fundamental elements resonate with the call for banking to focus on its core function of providing financial services that add value to the real economy.

[...]

Whilst Islamic finance has all the ingredients and the potential to meet the needs of the global economy, the channelling of funds to productive activities in Islamic finance today is still largely being carried out through non-participatory contracts, that includes the mark-up sale (Murabahah) and the lease-based (ijarah) structures, which continue to remain essential to cater for financing trade and the purchase of assets. Such contracts are similar to lending instruments which expose the Islamic financial institutions mostly to credit risk elements. Whilst non-risk-sharing contracts will continue to contribute to the future growth of Islamic finance, the wider use of risk-sharing transactions and undertakings under participatory finance models have significant scope in evolving a broader representation of Islamic financial products that will spur the next phase of industry growth and development. This includes participatory or equity-based contracts such as Mudarabah and Musharakah that support ventures involving entrepreneurship endeavours. Greater use of equity-based models in Islamic financial solutions has been observed in the more recent period. This has been most evident in the sukuk segment, with Shariah structures evolving from predominantly ijarah and murabahah structures to musharakah partnerships as well as convertible and exchangeable trusts. 

The further development of participatory Islamic finance contracts on a broader scale offers particular potential in efforts to reinforce links between finance and the real economy. Several elements of risk- and profit-sharing participatory contracts support this. As profit-sharing and loss-bearing are clearly identified and agreed based on the contractual agreements between the financier and the entrepreneur, strong emphasis is placed on the value creation and economic viability of productive efforts that create new wealth. In equity-based contracts, the financial intermediation is thus also directed towards promoting entrepreneurship, in that the clearly defined risk- and profit-sharing characteristics of the Islamic financial transaction provides strong incentives for both parties to contribute to the success of the investment. This also provides the foundation for a long-term trust-based relationship, and a clear interest for the financial institutions to undertake the appropriate due diligence to ensure that the returns are commensurate with the risks being assumed. Aspects of governance and risk management thus strongly underpin these contracts. In particular, such contracts demand higher standards of disclosure and transparency to be observed, which in turn act to strengthen market discipline.

[...]

Business risks of equity positions and ownership risks of underlying assets are, for example, embedded in these arrangements arising from the contractual relationships between the investors and entrepreneurs as well as the Islamic banking institutions as the intermediary of funds. Further in-depth applied research is also needed to develop more innovative financial products using risk and profit sharing structures with the corresponding development of risk management techniques. This also needs to be reinforced by enhanced consumer protection and education initiatives to deepen the understanding and awareness of consumers on the associated risks and rewards in the Islamic financial contracts, in particular for equity-based instruments.

Equally important in ensuring the institutional soundness of Islamic financial institutions is the need for robust liquidity management. Today, Islamic financial institutions operating in the different jurisdictions are still confronted with the challenge of managing their liquidity positions effectively, given the limited supply of high quality Shariah-compliant liquid instruments being the reason most commonly cited. The lack of high quality liquidity instruments for Islamic finance is not only constraining effective liquidity management, but it is also affecting the efficient cross-border diversification of financial flows. It is therefore our hope that through the mandate of the International Islamic Liquidity Management Corporation (IILM) in issuing high-quality liquid sukuks, it will contribute to promoting more efficient cross-border liquidity management by Islamic financial institutions whilst facilitating Islamic financial institutions in meeting the international requirements on liquidity.

A theme during the speech is a focus on keeping the Islamic finance industry focused on a connection with underlying economic activity, avoiding excessive leverage and maintaining as much diligence in the underlying businesses being financed.  This is, again, not anything groundbreaking, but it is interesting how she ties it in with the contractual form used in Islamic finance products (ijara/murabaha versus mudaraba/musharaka). 

The primary criticism I would offer of the Islamic finance industry's structure is that it is not only focused on replicating the same contracts as are used in conventional finance, it is replicating to a degree the same business models, with a skew towards the more leveraged business models (investment banking and private equity) at the expense of some that would fit in well with the ideal of risk sharing that Islamic finance is often described as being focused on

There is of course a need for Islamic finance to offer products with similar economics as conventional products for some needs (trade finance using murabaha, for example, or ijara as a substitute for conventional financial leases) but the danger comes when these contracts are used within the context of institutions that accumulate significant degrees of leverage on their own balance sheets. 

In this regard, Islamic commercial banks receive good marks since they have higher levels of capital for the most part and are not heavily leveraged, even though their balance sheets do include some leverage.  Islamic investment banks and Islamic private equity companies, however, which were the main casualties of the financial crisis, on the other hand, used high degrees of leverage in their business and paid the price when financial markets turned and they were unable to roll over their debts as the value of their assets fell. 

In the case of many of these, the institutions themselves were leveraged and their investments were also leveraged, amplifying the effect of a fall in the value of the assets they owned.  To use one company as an example (Arcapita), it had a $1 billion murabaha syndicated loan that the parent company took out to fund part of the investments it made in portfolio companies.  These companies were acquired as leveraged buy-outs, and Arcapita's equity interest was sold to investors, with a portion of the equity retained by Arcapita. 

While Arcapita would argue that it was the actions of an agressive minority of murabaha holders that led to their bankruptcy, these holders acquired the debt at a steep discount to par value because there was a fall in the value of their portfolio companies (many of which were acquired near the peak in 2006 and 2007) and the effect on Arcapita's balance sheet was magnified by the leverage employed on each buy out deal, which led to doubts that Arcapita had sufficient assets to pay its inter-bank liabilities, balances to unrestricted investment account holders and the murabaha holders.  Had the structure been less leveraged, it would have had a greater chance of avoiding bankruptcy. 

And this brings me back to Dr. Zeti's conclusion that the use of risk sharing contracts will force greater connection to the prospects of the businesses the Islamic financial institutions are financing.  While it will force some greater diligence because the risk assumed is more than just credit risk, there will be an important caveat that the market discipline from equity-based contracts will only be effective if the Islamic financial institutions themselves are not leveraged up and thus susceptible to the same types of risks that ended up bringing down many conventional financial institutions.